Companies often buy bonds to meet a future liability or cash outlay. Such an investment is called a dedicated portfolio
Posted: Wed Jul 06, 2022 6:27 pm
Companies often buy bonds to meet a future liability or cashoutlay. Such an investment is called a dedicated portfolio sincethe proceeds of the portfolio are dedicated to the futureliability. In such a case, the portfolio is subject to reinvestmentrisk. Reinvestment risk occurs because the company will bereinvesting the coupon payments it receives. If the YTM on similarbonds falls, these coupon payments will be reinvested at a lowerinterest rate, which will result in a portfolio value that is lowerthan desired at maturity. Of course, if interest rates increase,the portfolio value at maturity will be higher than needed.Suppose Ice Cubes, Inc. has the following liability due in fiveyears. The company is going to buy five-year bonds today to meetthe future obligation. The liability and current YTM arebelow.Amount ofliability: $ 90,000,000CurrentYTM:7.5%a.At the current YTM, what is the face value of the bonds the companyhas to purchase today in order to meet its future obligation?Assume that the bonds in the relevant range will have the samecoupon rate as the current YTM and these bonds make semiannualcoupon payments.Value ofliability today: